Can China spend its way out of trouble?

By John Garnaut

15 November 2008 — 12:00am

WENZHOU, the heartland of Chinese capitalism, is once again fighting for its survival. The city was famously forsaken by Maoist China but it stayed alive and later thrived by building one of the most entrepreneurial and dynamic marketplaces on the planet.

Wenzhou's manufacturers used to battle against the Communist Party's efforts to control them. Now, as China's export markets collapse and they are forced to turn inland, they are fighting against the market itself.

"We had more than 1000 workers, but now we are down to about 700. The rest have bolted home," says Shi Oubing, whose Triangular Cow factory made 3 million of the billion shoes produced last year in Wenzhou, a city ringed by mountains on the coast of Zhejiang province south of Shanghai.

"After another month, another half will leave and we'll just have 300 and most of them will be managers  they can sweep the floors and look after the dog," he continued. "You journalists are always writing about the peasants having to go home, but where do we go? Wenzhou now is an empty city."

The story is similarly bleak in many of the Wenzhou factories, which together boast of making 90% of the world's cigarette lighters, a third of all sunglasses and a sizeable chunk of the world's razors, padlocks and coloured pens.

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Millions of migrant workers who had been supporting tens of millions of relatives in the Chinese countryside are now returning home. China's phenomenal urbanisation and industrialisation has temporarily reversed.

"Our factory makes speedometers for motorbikes, but half of us have left," says Deng Shoushui, a 41-year-old migrant worker, as he waits at Wenzhou Station with his wife and a sack containing their doona and a wok. They are returning to neighbouring Jiangxi province, where they used to own a small plot of land before village leaders redistributed it to the peasants who stayed around. "I'll wait until my brother phones to say Wenzhou has recovered and then I'll check it out again in the new year," says Deng.

The Chinese economy was important to the world a year ago, when all the major regions were firing. Now it is just about the only hope.

If China grows at 8% or 9%, as central bank governor Zhou Xiaochuan says it will, then China will contribute more than one half of total global growth next year when measured at market exchange rates. That proportion is even greater if the purchasing power parity measure is used to take account of China's relatively low prices.

Most analysts thought the Chinese leadership would wait for an important economics work committee meeting later this month before injecting money into the system. But the data were heading south too fast for that. On Sunday night the State Council unveiled the single biggest fiscal rescue package in global history, with a headline value of 4 trillion yuan.

Prime Minister Kevin Rudd saw parallels with the Asian Financial Crisis, when the Chinese Government kept the nation occupied (and helped Australia avoid recession) by laying nearly 200,000 kilometres of roads and freeways across the country.

Mr Rudd told the ABC yesterday: "China also I believe is acting not just in its national interest, but has also realised that if it adds to growth in its own economy it helps the wider region and it helps the global economy as well  as China did after the 1998 Asian financial crisis."

On Monday, after the Chinese stimulus announcement, the world's battered investors enjoyed a rare moment of optimism and markets surged across Asia. But the week wore on and the flow of data from China went from bad to alarming. By Thursday investors had folded themselves back into their crash positions and the Australian sharemarket swooned to a new four-year low.

While exports were gradually slowing in October, as expected, imports fell so suddenly that China still managed to post the world's largest-ever monthly trade surplus of US$35 billion.

Retail spending and inflation are slowing faster than expected and on Thursday China's bureau of statistics said industrial production growth  the single biggest driver of the five-year resources boom  has suffered its sharpest decline in at least 17 years.

The growth rate in cement production  remembering that China produces half of the world's cement  fell from 26% in March to 1% in October. In steel, where China produces nearly two-fifths of the world's output, annual production growth fell from 12% in March to negative 17% in October. Production of white goods and cars is also falling.

Incredibly, growth in electricity production  which some economists use as a quick proxy for gross domestic product  collapsed from 17% in the year to March to negative 4% in the year to October. The November figures will be far worse because the top five power companies only began slashing production in the last two weeks of October, according to industry insiders. Among other things, this means global demand for coal  Australia's most important export  is collapsing and prices will soon follow. Declining building activity suggests the industrial downturn will get worse before it improves.

China's construction sector and the heavy industries that supply it are clearly in a savage recession. Millions of workers are being laid off. Real estate prices are falling, commodity prices are tumbling and consumers and investors are running for cover.

All this is happening while the official figures suggest that the decline in export growth has only just begun. If forward orders are any guide, the growth in export volumes will fall from 10% in the year to October to below zero in the early months of next year.

Zhou Dewen, at the Wenzhou business association, says Wenzhou's factory owners have greater fortitude than those who are shown on TV to be fleeing from Guangdong. He estimates 20% of local manufacturers are in trouble and 80% are OK. But local businessman Shou Minghuan, whose sunglasses factory has closed four of its five production lines, says it's the other way around.

Shou says the Government is "foolish" to suggest shifting from exports to domestic customers, even if China's domestic consumers had money to spend.

"I'm not game to do business with Chinese businessmen, because they don't pay," he says.

The market, it seems, has judged that the Chinese Government's enormous fiscal resources are not enough to save China, let alone the world. Analysts pointed out that the Chinese stimulus package was so vague that it was impossible to tell what money was new and what was already spent. Morgan Stanley cut its China growth forecast. Others noted exports are now twice as important to GDP growth as they were 10 years ago, and that no amount of Government assistance can restore China's export markets.

Many analysts, particularly outside mainland China, said rapid privatisation meant that China is a vastly different enterprise to what it was 10 years ago. They said the Chinese Government no longer had the power to override the business cycle.

But perhaps the world has overestimated how far China has evolved towards a private market economy; and therefore it has underestimated the power of the Communist Party to cushion the fall of the world economy. Even in Wenzhou, birthplace of Chinese capitalism, the most successful entrepreneurs are not as independent as they seem.

Li Anlian boasts that she started with just 5000 yuan and a backyard assembly line in the late 1980s and has risen to become one of China's free-market success stories. Last year earnings at her Juyi shoe and property company exceeded 2 billion yuan.

Her company's most important market, Germany, is in recession. But management is taking the financial and economic crisis in its stride.

"We raised production in September and October and we have switched our focus from overseas to domestic markets," says Qi Yinong, vice general manager at Juyi shoes. "And the Government is helping us to expand."

Juyi is a well-run enterprise, but no successful Chinese entrepreneur can display such confidence without earning the patronage of the gatekeepers of China's land, finance, labour and government largesse. These patrons are prominently exhibited throughout the elaborate corridors of Juyi's corporate headquarters.

More surprisingly, at least to a foreign observer, the company has a luxurious Communist Party Members Room which is lined with life-size portraits of Karl Marx, Friedrich Engels, Vladimir Lenin, Joseph Stalin, Mao Zedong and Deng Xiaoping. The large character caption reads: "The Communist Party of China is the Core Power that Leads Us."

The room, like the banners proclaiming President Hu's "Harmonious Society", is a shrine of corporate loyalty to the party rather than any indication of ideological bent. Ultimately, loyalty to the party is shown at times of crisis. And now, facing an economic crisis and massive unemployment, the Communist Party's leadership is signalling to all tiers of government and all varieties of enterprise that it is time to spend, spend and spend.

Juyi has been following the Government's long-standing instructions to switch to domestic markets, upgrade technology and consolidate the industry. After this week's encouragement, they are accelerating plans to build a huge new factory in neighbouring Jiangxi province where labour is cheaper and it is more convenient to supply domestic consumers.

Juyi's enthusiasm hints at the central leadership's vast power to shape the economy, even in a capitalist bastion like Wenzhou. Elsewhere, the levers of control are more direct. The Government can spend the money directly. Or it can lean on the executives of large state-owned companies, who are all appointed by the Communist Party's personnel departments and who accounted for one-fifth of China's GDP even before the Government pushed its policy levers into overdrive this week.

Huang Yiping, Citigroup's chief economist for Asia, believes some analysts have vastly underestimated the Chinese Government's ability to command the economy, including its capacity to increase the supply and discount the price of land, labour, credit and natural resources.

"We should not underestimate the Government's ability to mobilise resources to support growth," he says. "In fact, its ability has probably strengthened compared to 10 years ago during the East Asian financial crisis."

China's GDP growth rate dipped below the Government's self-imposed minimum of 8% during the Asian financial crisis, in both 1998 and 1999. But Mr Huang reels off a list of reasons why the Chinese Government won't fall short this time around.

Since then, government revenue has doubled to 21% of GDP, state sector profits have quadrupled to 23% of GDP, non-performing bank loans have shrunk by 75%, foreign exchange reserves have swollen 13-fold to $US1.9 trillion. China's bank deposits now stand at 150% of GDP  which is similar to the ratios of household debt in English-speaking Western countries.

Chinese banks, enterprises and households have money to burn  and the Government can lean on them to burn it. Private banking channels that were considered illegal last week are suddenly patriotic. Governments are bailing out distressed companies everywhere. Local Governments are dusting off their shopping lists and banks are simply being directed to finance them.

While Western analysts were estimating that only about a third of the State Council's promised 4 trillion yuan would be fresh money, local media are saying the announcement will trigger 5, 6 or even 10 trillion yuan of new investment at all levels of government. These figures are vastly exaggerated but the phenomenon is real. The Chinese Government will spend, command and ultimately persuade the economy to grow  because it thinks its life depends on it.

Wenzhou's economy had plunged with the political temperature in the early 1990s, with GDP growth hitting close to zero in both 1990 and 1991. After Deng Xiaoping's famous "southern tour" in early 1992, conservative local ideologues were replaced, private banking controls were loosened and entrepreneurs came back out into the open. Wenzhou's economic growth rate soared to 18% in 1992, 31% in 1993 and 42% in 1994.

Wenzhou is now too big to grow that fast again and its export markets are too sick. But many of China's business leaders can see a way through.

"The Government's macro control policy has made most enterprises see hope," says Zhou Dewen, the Wenzhou business association head.

"It adds great confidence. It will mean that private (underground) banking will be legalised, taxes are cut, demand will be restored and China's small and medium businesses will survive."